OMO is not the right tool to address liquidity
The RBI has announced an Rs 10,000 crores OMO (Open Market Operation) purchase of bonds on the 24th of November 2011. The reason for the bond purchase was the structural change in liquidity conditions, which could hamper the normal functioning of markets.
The RBI conducted OMO’s the same time last year on the basis of liquidity conditions becoming extremely tight. The RBI bought over Rs 60,000 crores of bonds through the OMO purchase auctions. Liquidity eased on the back of OMO auctions but at the same time inflation kicked up and started trending at close to double digit levels, forcing the RBI to raise policy rates to bring down inflation expectations.
Why is RBI persisting with OMO’s? An Rs 10,000 crores OMO auction will hardly bring about easing liquidity conditions as the system is borrowing over Rs 100,000 crores from the system. An OMO also sends out wrong signals of the central bank supporting the government’s fiscal deficit, which is inherently inflationary. An OMO under fiscally constrained conditions is irreversible. As the RBI cannot conduct OMO sales when the government is borrowing money on a weekly basis.
Bond markets too are cool to OMO’s as it is ineffective in bringing down bond yields as seen in the last OMO’s. Bond yields had in fact gone up despite OMO’s with ten year bond yields rising by 20bps through the OMO’s. The market is not going to welcome this OMO with open arms, though there could be some treding down of bond yields as yields had gone up by almost 70bps since September end on the back of higher than budgeted government borrowing.
On the other hand a CRR (Cash Reserve Ratio) cut would have been more effective as even a 50bps would have added over Rs 25,000 crores into the system. A CRR cut is not inflationary when liquidity is tight and is not seen as the central bank supporting government borrowing. A CRR cut can also be easily reversed if inflation threatens to rise further.
Persisting with an OMO when it does more harm than good as seen in the previous OMO’s (distorting yield curves, adding volatility to the market etc.) either tells that RBI believes that OMO is the right liquidity instrument or that it does not have other tools that can be more effective.